Asset Allocation for the Self-Employed

Dear Dr. Don,

I am a 36-year-old male, married, with no children. My wife is 31. We plan on having two kids within the next two years. We both used to work for companies, but each of us is now self-employed. Last August I rolled the 401k funds into an IRA Rollover money market account. I am now ready to initiate my first real asset allocation.

In addition to our IRA rollover, we have a $30,000 emergency fund, which represents six months' worth of expenses, invested in a three-month CD earning 4.15%. I also have $40,000 on deposit for income tax payments. We both plan on retiring in our early 60s and if we invest wisely, perhaps even in our late 50s.

Beyond the emergency and income tax reserves, the following is my proposed asset allocation:

25% Large Cap Growth ($20,000): (WOGSX Quote)White Oak Growth Stock

11% Large Cap Value ($8,500): (DODGX Quote)Dodge & Cox Stock

16% Mid Cap Value ($13,000): (CFIMX Quote)Clipper

10% Small Cap Growth ($8,000): (BRAGX Quote)Bridgeway Aggressive Growth

5% Small Cap Value ($4,000): (BSVIX Quote)Berger Small Cap Value

28% International ($22,000): (TBGVX Quote)Tweedy Brown Global Value

5% Bond ($4,000): (DODIX Quote)Dodge & Cox Income Fund

In searching for these funds, my criteria generally focused on funds with no loads, five- and 10-year total return outperformance compared both to its category and the S&P 500, veteran managers, low management fees, reasonable P/E ratios and, to a lesser degree, four- and five-star rankings by S&P and Morningstar.

We also own approximately $18,000 worth of Johnson & Johnson(JNJ Quote) and Microsoft(MSFT Quote) as the start to our aggressive goal to build a home where we live within the next four years. I plan to add to the JNJ position from available cash in my taxable account. We need approximately $500,000 to build our own house, and my current annual earning potential ranges from $125,000 to $300,000. My wife's business annually produces about $25,000 of net income.

I would like to know if I am diversified enough to prevent any nasty dips in my overall portfolio while capitalizing on a rising market. I am also curious if my choice of using CDs to fund our emergency fund and tax fund is too conservative. I looked at TIPS (Treasury Inflation-Protection Securities), but they didn't seem to work for me. Thanks for your help.

Regards,

MS

MS's Taxable Account
Name	Shares	Market Price	Market Value	% Total Value	YTD Return	Stock Industry or Fund Category*
Cash	5,883	1.00	5,883	4.3%	n/a	Money Market Fund
Emergency Fund	30,000	1.00	30,000	21.9	n/a	Certificate of Deposit
Johnson & Johnson(JNJ Quote)	150	50.41	7,562	5.5	-3.37	Household Products
Microsoft(MSFT Quote)	150	66.06	9,909	7.2	52.30	Software
Account total:			53,354	39.0%
MS's IRA Accounts (SEP, Rollover)
Name	Shares	Market Price	Market Value	% Total Value	YTD Return	Stock Industry or Fund Category*
Cash	64,666	1.00	64,666	47.2%	n/a	Money Market Fund
Cash	1,283	1.00	1,283	0.9	n/a	Money Market Fund
Cash	584	1.00	584	0.4	n/a	Money Market Fund
Cash	1,315	1.00	1,315	1.0	n/a	Money Market Fund
(WOGSX Quote)White Oak Growth Stock	127	41.18	5,230	3.8	-35.63%	Large Growth
Account total:			73,078	53.4%
MS's Roth IRA Accounts (Self, Spouse)
Name	Shares	Market Price	Market Value	% Total Value	YTD Return	Stock Industry or Fund Category*
Cash	4,008	1.00	4,008	2.9%	n/a	Money Market Fund
Cash	4,009	1.00	4,009	2.9	n/a	Money Market Fund
(WOGSX Quote)White Oak Growth Stock	60	41.18	2,471	1.8	-35.6%3	Large Growth
Account total:			10,488	7.7%
Portfolio total:			136,919	100.0%
*Morningstar categories

MS,

When you've kept money on the sidelines in cash to the extent that you have, it's difficult to determine when the time is right to start reinvesting in the stock market. You can leap in with both feet, or take a more cautious approach and buy in over time. The longer your investment horizon, the less concerned you need to be about averaging in your stock purchases.

Since you've got cash to invest in taxable, tax-advantaged (Roth IRA) and tax-deferred (IRA) accounts, you also need to consider the best way to allocate your investments between the different types of investment accounts. Qualified distributions from your Roth IRA will be tax-free, so you're indifferent between capital gains and ordinary income in that account. Qualified distributions from traditional IRAs are taxed at your ordinary income tax rate. Capital gains in your taxable account are taxed at the lower capital gains rate when recognized. Holding individual stocks in taxable accounts lets you manage when you realize capital gains or losses.

Mutual funds have to pass on their gains and income in the year that they are realized, so the fund manager is deciding your tax exposure in a mutual fund. Tax efficiency can be an important consideration when investing in mutual funds in a taxable account. Put the efficient funds in the taxable account and the inefficient funds in the IRA or Roth IRA accounts.

I'm going to split the difference with you and tell you that I consider your emergency reserves to be part of your investment portfolio, but not the income tax reserve. Because both you and your wife are self-employed, an emergency cash reserve is a very important part of your portfolio. I'd consider six months of expenses to be too conservative for salaried employees in your financial position, but not for entrepreneurs like you. Right now it's a large percentage of your portfolio, but as you continue to fund your SEP IRAs, you'll see that percentage decline.

When your investment horizon is just four years away, as it is for the purchase of your new house, you shouldn't count on stellar performances by a couple of stocks in order to reach your goal. It's not clear to me whether you're planning to pay cash for your new home or expecting to finance it, but, regardless, when your portfolio has to outperform in order to reach your goals, you take on a level of risk that increases the probability that you won't reach your goal.

If you went ahead with your proposed allocation, here's how your portfolio would look:

The Reallocation
Name	Shares	Market Price	Market Value	% Total Value	YTD Return	Stock Industry or Fund Category*
(BRAGX Quote)Bridgeway Aggressive Growth	195	41.06	8,007	5.8%	-4.9%	Mid-Cap Growth
(BSVIX Quote)Berger Small Cap Value Instl	142	28.26	4,013	2.9	11.1	Small Value
(CFIMX Quote)Clipper	160	81.13	12,981	9.4	2.5	Large Value
(DODGX Quote)Dodge & Cox Stock	84	101.24	8,504	6.1	7.0	Large Value
(DODIX Quote)Dodge & Cox Income	331	12.08	3,998	2.9	5.5	Interm-Term Bond
Johnson & Johnson(JNJ Quote)	150	52.12	7,818	5.6	-3.4	Household Products
Microsoft(MSFT Quote)	150	65.69	9,854	7.1	52.3	Software
(TBGVX Quote)Tweedy, Browne Global Value	1,088	20.23	22,010	15.9	1.1	Foreign Stock
(WOGSX Quote)White Oak Growth Stock	486	41.18	20,013	14.4	-35.6	Large Growth
Cash	35,883	1.00	41,619	30.0	n/a	Cash
Account total:			138,817	100.0%
Morningstar categories

Before considering your plans to invest additional money in Johnson & Johnson and ignoring the reserve for taxes, you'd have 67% of your money invested in stocks, 30% in cash and 3% in bonds (that weighting ignores the cash holdings in the stock and bond funds). Investing $22,000 of the $79,500 you plan to invest in stock mutual funds in the Tweedy Browne Global Value Fund places too much emphasis on foreign stocks in your stock portfolio.

Don't ignore how your investments in Microsoft and Johnson & Johnson change your sector weightings and capitalization weightings. For example, your investment in Johnson & Johnson along with White Oak Growth Stock's emphasis on health stocks causes the health sector to be overweighted in your stock portfolio. Both Johnson & Johnson and Microsoft are considered to be large-capitalization growth stocks.

One of your biggest decisions in reallocating your portfolio is your commitment to the White Oak Growth Fund. The fund's investments are very focused. The managers have shown a willingness to stick by their stock picks rather than flail about when their stocks fall in value. The fund is tax-efficient, so you shouldn't expect a lot of turnover. That should mean that you could look at their holdings and make a decision to invest in the fund based on the prospects of the stocks currently held in the portfolio.

Your fund-selection criterion has allowed you to come up with a respected list of fund investments. Still, I'd like to see you throttle back on the stock pickers and get some exposure to a broad-based index fund. Consider an S&P 500-based index fund for 15% to 20% of your stock portfolio and then get your small- and mid-cap exposure elsewhere.

Speaking of small-cap exposure, the Berger Small Cap Value Fund (Institutional Shares) is closed to new investors, but it may continue to be available to you through an existing account relationship that the fund has with the custodian of one of your retirement accounts. If not, then go shopping for a replacement fund.

Send In Your Portfolio

If you would like to submit your portfolio for a makeover, send it to [e-mail]. Give us enough details -- dollar values or percentages -- so we can determine how your assets are allocated. Also tell us a little about yourself and your investing goals, and let us know how we can contact you if we have further questions. Though we'll use only your initials publicly, please include your full name so we can verify your identity. Unfortunately, we cannot guarantee your portfolio will be selected for a makeover, nor can we promise to respond individually to everyone who submits a portfolio.